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dumb bull ivan wrote a post · Oct 15, 2024 12:15

Understanding Options Part 1

Hohoho, back with another post. One thing that is very daunting or hard for new investors to grasp is the concept of options. And as usual, I'm here to try to make it simpler to understand in layman terms, or at least I hope, its hard to simplify options, but I'll try my best!
What is an option?
An option is essentially a contract that represents 100 shares (for US options, or 1 lot). You will thus need to x100 the price of the options price. An option consists of 4 main components:
1) the underlying
2) the expiry
3) the strike price
4) the direction (call/put)
So a SPY call, with strike 580, that expires on 15th Oct 2024, will show something like:
SPY CALL 20241015 580
The date is usually in US date format (YYYYMMDD)
*Please take note of date format, some brokers show as DDMMYYYY or even MMDDYYYY or even YYYYDDMM
I even colour coded it for you guys
Lets break things down, I think underlying is very simple to understand and needs no explanation here. Lets start with expiry.
For options, an option has an end to the contract, meaning that at the end of the day, come the options expiry date, the options either expire in the money (ITM) or out of the money (OTM). An option that expires OTM is usually called, expiring worthless as well.
The strike price. This is the price that you have promised to buy or sell the underlying come the expiration date, if the option is in the money.
Call/Put. This determines the direction, a call option represents that you want to buy/long, meaning if price goes up, its good. As for the put option, it represents that you want to sell/short, meaning if price goes down, its good.
Likewise with stocks, you can BUY or SHORT a contract (think of this as adding a "-" sign in the direction you want to simplify things), meaning:
BUY CALL = I end up with +100 shares
SELL CALL = I end up with -100 shares
BUY PUT = I end up with -100 shares
SELL PUT = I end up with 100 shares
Putting everything together, for instance I bought a CALL option for $SPDR S&P 500 ETF (SPY.US)$ for 580, with expiry 20241015, and market closes at 585, my option would be IN THE MONEY, of which I am able to buy 100 shares of SPY at $580 (cheaper than market price of 585).
However, if the price of SPY falls below 580 at market close of my options, my option expires worthless.
So how do we put this into trading? Options aren't free. It costs money (premium) to enter the contract. I think an easier analogy would be to think of the options contract for a house. Lets say you enter with the developer to buy a house for 1million, when the house builds finish in 3 years time. You paid 10k to enter this options contract to lock in the deal. 1 year later, the government announces that there will be a new subway line, a 3minutes walk away from your upcoming house, sending the value of properties around the area up 50%, yours included, meaning that your house is theoretically worth 1.5mil now.
Are you able to see that your option contract that you entered for 10k, that allows you to buy at 1million is now worth at least 500k? (1.5mil current value of house - the 1mil you could have bought it for)
Inversely, if there's an event to drive the price of your house down to lets say 800k, would you still want to fulfil your obligations of the contract to buy the house at 1mil? If you're a sound investor, you would say no to the developer and rather buy it at market price at 800k. As such your option is worthless and you lose money from the premium only (10k in this case)
Now apply that to stocks. In the case of the SPY example, assuming I entered the contract at 200 USD (charts will show it as 2.00), and SPY ends the day at 585. Do you see how my contract is worth at least 500 USD now? [(585 - 580) x 100]
Soooo what determines the price of options? Options are usually calculated via the Black-Scholes Model, the calculations are complicated, and I honestly don't know as well. But the calculations are based off what we call the Greeks (called that as they are based off the Greek alphabet, just like in math), which are mainly:
1) Delta - the change in options price, for every $1 the underlying moves.
2) Theta - time decay, the closer the option is to expiry, the cheaper it is
3) Rho - the rate of change of an option price
4) Gamma - measures the rate of change of delta
5) Vega - the risk of changes in IV
For the layman investor, Delta and Theta is the most important, followed by Vega. You can honestly ignore Rho and Gamma (but its good to know). So how does this all come to play?
Understanding Options Part 1
Example of SPY 580C for 15th Oct 2024 expiries (screenshot from Moomoo), do you see at the bottom, the greeks being highlighted? Lets start with Delta
0.8297 delta means that for every $1 that SPY increases, the option increases by 0.8297, so if we follow the above screenshot, should SPY go to 584.68 (up $1), the option would thus be priced at 4.06 + 0.8297 = 4.89 (rounded off to 2dp). In general, the more in the money the price is relative to the strike price, the higher Delta is.
Now for Theta, as you can see -0.4208, with everyday, my option loses this value, so assuming SPY stays the same price, come tomorrow, our contract would be worth 4.06 - 0.4208 = 3.64 (rounded off to 2dp). In general, the further out the expiry, the lower Theta is.
Now comes Vega, to understand Vega, you have to understand what is Implied Volatility. In very layman terms, when a stock makes VIOLENT moves, IV increases. And during this period, options get more expensive. Higher IV = more expensive contracts. (think of violent events, such as earnings, where price of a stock is expected to move quick and fast - I'm looking at you $Tesla (TSLA.US)$ and $NVIDIA (NVDA.US)$)
Options contracts can be bought and sold anytime, just like your usual stocks (market hours only, pre/post market do not apply to options). Soooooo, as you can see, should you want to invest in a stock, but don't have much capital to it, you CAN buy an options contract to be able to partake in the price movement as per your analysis, to profit almost the same as what you expected the move to be. HOWEVER - the part that makes people think options are risky is that, should the price move against you, options contract LOSE VALUE fast and quick as well. Please manage your risk properly in options.
Got the hang of the basics? More to come in the next sharing, I hope your brain grew a wrinkle or two!
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dumb bull ivan
Just a dumb bull believing that stonks only go up... until there's a reason to cut and cosplay as a bear
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